Severance Pay in Employment Law

October 2026 – Authors: Attorney Volker Mauch, Attorney Till Heinrich

Have you received a notice of termination and are negotiating a severance package? If so, in addition to the amount of the payment, you should also be aware of and take into account the legally sound structure of the agreement as well as any potential legal, social security, and tax implications.

The starting point for any severance negotiation is assessing your own bargaining position. This is because the amount of a severance payment is, in principle, freely negotiable. In addition to the legal prospects of success in an unfair dismissal lawsuit, the decisive factors here are, in particular, the amount of your salary, the strength of your protection against dismissal, and the employer’s willingness to take risks.

The last gross monthly salary is generally the key benchmark for determining the amount of a severance payment. This includes all components of compensation such as allowances, bonuses, commissions, Christmas and vacation pay, as well as regularly worked overtime (see Schröder – Grobys/Panzer-Heemeier, StichwortKommentar Arbeitsrecht, “Action for Unfair Dismissal,” paras. 57–60). However, employers often attempt to base the severance pay solely on the base salary, which would result in a correspondingly lower severance payment.

The specific agreement between the employer and the employee should expressly address several points. For example, it should stipulate that the severance pay is paid “gross,” becomes due upon the legal termination of the employment relationship, and is inheritable. A proven formulation stipulates that the employer pays a severance payment in a specific gross amount in accordance with §§ 9, 10 KSchG, that the claim arises upon the conclusion of the settlement, is inheritable, and becomes due upon the termination of the employment relationship (see Michels, BeckRA-HdB, § 8. Labor Court Proceedings; Protection of Acquired Rights, paras. 233–245).

Finally, ancillary matters must be negotiated. These include a detailed employment reference, vacation pay, time off, and the question of whether the severance payment constitutes a comprehensive settlement of all claims or whether supplementary claims—such as compensation for delay in acceptance—exist in addition.

Entering into a termination agreement without prior notice of termination by the employer typically triggers a twelve-week waiting period for unemployment benefits and also shortens the duration of entitlement pursuant to § 159 SGB III (see Küsters – BeckStB-HdB 2023/2024, Section Labor Law, para. 1-369). Such a waiting period can be avoided, in particular, if the employer first issues a termination for operational reasons and the severance pay is based on the principles of § 1a of the German Employment Protection Act (KSchG). This will typically be the case if the employee allows the three-week deadline for filing a lawsuit to expire and remains passive, or if the agreement is reached after the termination has been issued as part of a court-mediated settlement.

However, a formal notice of termination is not strictly necessary to avoid the waiting period in the case of a severance settlement. According to the case law of the Federal Social Court, even the threat of a lawful termination may be sufficient grounds to permit a severance settlement to avert such a termination without resulting in a waiting period. The prerequisite is that the notice period is observed and the amount of the severance payment falls within the limits set forth in Section 1a(2) of the German Employment Protection Act (KSchG). In contrast, for significantly higher severance payments or where there is no business-related reason, a case-by-case review is necessary. This is because, in such cases, case law identifies indications of a “buyout” at the expense of the insured community, which would result in a waiting period.

If the employment relationship ends before the expiration of the applicable notice period, there is also a risk that the entitlement to unemployment benefits will be suspended under § 158 SGB III: In such cases, the employee must first “use up” the severance payment—generally, 60 percent of the gross monthly salary is counted toward this requirement—before unemployment benefits are paid, for a maximum of one year; unlike the waiting period, this does not reduce the duration of entitlement but postpones the start of benefits (Knorr – BeckOGK | KSchG § 1, paras. 1687–1691) (Ganz – PersLex | “Employee Termination—Waiting Period, Unemployment Benefits”). In practice, this means: The standard notice period should be observed whenever possible. For foreign clients, it is also important to note that the waiting period and the cooling-off period can affect the issue of securing a livelihood and, consequently, the assessment by the immigration authorities.

A severance payment is taxable wages. Social security contributions are not due on severance payments.

However, as compensation for the loss of employment, it constitutes extraordinary income within the meaning of § 24 No. 1 EStG and is subject to reduced taxation upon application. The resulting potential tax benefit is the so-called “one-fifth rule” under § 34(1) of the German Income Tax Act (EStG), which, however, requires a request (see Joachim Holthausen – PersLex; “Termination Agreement – Severance Pay” Labor Law).

Under the one-fifth rule, the tax on the severance pay is calculated in several steps:

First, income tax is calculated on the taxable income excluding extraordinary income. Next, tax is calculated on the income increased by one-fifth of the severance payment. The difference between these two amounts is then multiplied by five. The result corresponds to the tax liability on the severance payment.

The one-fifth rule is therefore not a true distribution over five years, but rather a tax instrument designed to mitigate the effect of the severance payment being added to the taxpayer’s other income for the year and thereby driving up the tax rate (see Bauer/Krieger/Arnold, Termination Agreements, Section H. Tax Optimization, para. 53).

The conditions and limitations of the tax benefit are decisive for structuring the arrangement:

• First, the payment must actually constitute compensation for the loss of employment. Payments that merely serve to fulfill the employment contract, or compensation for the period of leave of absence, do not qualify for the tax benefit.

• Second, the one-fifth rule requires that the severance payment be received in a lump sum within one year. Partial payments spread over two tax assessment periods do not qualify for the preferential treatment. Even in the case of a severance payment intended as a lump sum, an advance payment made in the previous year negates the benefit. The decision between “all in one year” and “spreading out” must be carefully weighed. In particular, the amount of other income in the respective year is decisive.

• Third, the one-fifth rule offers no advantage for very high incomes. If the remaining taxable income is already in the range of the top tax rate, the tax benefit is zero. If, on the other hand, the total income excluding the severance payment is negative, then—by way of exception under § 34(1), sentence 3, of the Income Tax Act (EStG)—five times the tax is levied on one-fifth of the taxable income (see Bauer/Krieger/Arnold, Termination Agreements, Section: Tax Optimization, paras. 74–78).

• Fourth, the employer must correctly apply the reduced tax rate when withholding income tax. If the employer fails to do so, it may be liable for damages to the employee under § 280 BGB. The settlement statement for the severance payment should therefore be carefully reviewed. Finally, while tax-neutral, this is relevant from a negotiation strategy perspective: An explicit clause stating that the employer pays “gross” or even covers the income tax should be expressly agreed upon, since the amount paid out is lower due to the tax withholding and a net settlement would need to be explicitly stipulated.

Have you received a notice of termination, been offered a severance package, or are you already in negotiations regarding a severance package and need expertise and experience? Contact us.